Mutual funds offer many benefits, such as convenience, transparency, liquidity, low cost, flexibility, and diversification, but there are also certain risks associated with it.
Indians have always preferred to invest in gold, real estate, and bank fixed deposits. Now, more and more people are opting to invest in mutual funds regularly through Systematic Investment Plans (SIPs). Those who have remained invested in mutual funds for long periods have earned high returns.
However, many new investors are not aware of the risks associated with investing in mutual funds. They have never experienced a significant fall in the stock markets like the one that occurred in 2008. A stock market crash can result in a loss of capital. Here we will look at the risks that you need to be aware of before investing in mutual funds.
Mutual fund investments involve risk
Mutual funds don’t offer guaranteed returns like bank fixed deposits, and there is no government guarantee or deposit insurance. The returns depend on the investments made by the fund manager. The level of risk associated with a mutual fund depends on the instruments in which it invests.
For example, an equity fund is riskier than a bond fund, and a diversified equity fund is safer than a thematic fund. In the same way, a large-cap fund is more reliable than a mid-cap or small-cap equity mutual fund.
Mutual funds invest in financial instruments like equities, bonds, and government securities. The returns vary due to various factors, such as inflation, interest rates, demand and supply, and global and local economic trends.
The value of the assets held by a mutual fund fluctuates, and this affects the Net Asset Value (NAV). The NAV of a mutual fund is the market value of the scheme, and the fund house declares it on a daily basis. The NAV is the price at which you can redeem your mutual fund investments or make additional investments on that day.
Every mutual fund category has a distinct risk and return profile. You need to consider your goals, age, period, return expectations, and risk tolerance before choosing a mutual fund. It’s best to seek professional advice if you feel you may not be able to do this yourself.
Let’s take a closer look at the types of risks associated with mutual fund investments in India:
Also Read: 8 Commonly Used Mutual Fund Terms & Jargons A Newbie Investor Must Know
1.Interest rate risk
The interest rate changes based on how much credit lenders are offering and the demand for credit among borrowers. If the interest rate rises during the investment period, the price of the security falls.
For example, let’s assume that you invest Rs. 1 lakh for a certain number of years at 8% and the interest rate rises to 10%. You will not be able to withdraw your money because of the fixed interest rate. Your only option will be to reduce the market value of the bond. If the interest rate falls to 7%, you can sell the bond at a higher price.
2.Market risk
Mutual fund advertisements include the following disclaimer:
“Mutual fund investments are subject to market risks. Please read the scheme information and other related documents before investing.”
This disclaimer means that an investor can suffer a loss if the market falls. The market could collapse due to a variety of factors, such as interest rate changes, political instability, recession, inflation, disasters, and war. Diversification may not help you in a situation like this. All you can do is to lie low and wait for market conditions to improve.
Also Read : Should we time the market while investing in mutual funds?
3.Credit risk
At times, the scheme’s issuer may not be able to pay interest or return the principal. Rating agencies assess firms that manage investments. Firms with higher ratings are safer but they offer lower returns than those with low scores. However, scores may not always be reliable because those being rated pay the rating agencies, resulting in a conflict of interest. Instruments with AAA ratings have been known to drop to junk status within months.
Mutual funds, especially debt funds, are also exposed to credit risk. Debt fund managers often invest in securities with lower ratings to boost returns. Investment in securities with low scores increases the level of risk for investors. It’s essential to check the credit scores of the instruments in a mutual fund’s portfolio before investing.
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In certain situations, it may be hard to redeem your investment without incurring a loss. Redemptions can take time when a seller is not able to find a buyer for the security. For example, people who invest in Exchange Traded Fund (ETF) may also face liquidity risks. Investors buy and sell ETFs on stock exchanges like shares, so they may not be able to find buyers for their ETF units quickly.
Those who invest in Equity Linked Saving Scheme (ELSS) mutual funds also face liquidity risk. You cannot redeem your ELSS investments during the lock-in period of three years. To reduce the liquidity risk, diversify your portfolio across different types of assets. Select a mutual fund with a proven track record.
5.Concentration risk
You will face a concentration risk if you put all your money in a single mutual fund scheme. If it does well, you will make a lot of money. However, if its performance is weak, you could even lose a part of your capital. A young person may be able to recover, but a retiree may find it very hard to compensate for the loss.
To avoid this situation, diversify your investments across different assets, categories, fund houses, and schemes. However, investing small amounts in too many mutual funds of the same type causes over-diversification. Having too many mutual funds is like investing in the index, and it will reduce your returns.
Conclusion
Mutual funds offer several benefits when compared with direct investments in stocks and bonds. They offer safety, diversification, transparency, liquidity, attractive returns, and more. However, you need to understand the risks before investing in mutual funds. Diversification across different types of assets, categories, and schemes helps to reduce risk. Consider your priorities before investing and remember that past performance may not repeat itself in the future.
